Sun posts profit, gets private investment

Sun Microsystems on Tuesday posted a profit that beat Wall Street's financial expectations for its most recent quarter, and announced a $700 million investment from an arm of private equity firm Kohlberg Kravis Roberts.

The software and server maker reported revenue of $3.57 billion, a 7 percent increase from the year-earlier period, and earnings per share of $126 million, or 3 cents per share, using generally accepted accounting principles.

Excluding $58 million of stock-based compensation, $26 million of restructuring and asset-impairment charges and a $4 million tax benefit, Sun had income of 5 cents per share for the quarter, which ended December 31. That's well above the average of 1 cent per share expected by analysts surveyed by Thomson First Call. In addition, Sun's revenue exceeded that expectation of $3.52 billion.

"I'm very pleased with our second-quarter results," which show turnaround progress and customer confidence, Chief Executive Jonathan Schwartz said on a conference call. "We are very optimistic, and we are operating from a position of strength."

Sun's stock rose 47 cents, or 8 percent, to $6.13 in after-hours trading. The Santa Clara, Calif.-based company has been struggling to return to profitability for years, though it's not the first time since the dot-com crash that the company was in the black.

In addition to reporting earnings, Sun also announced that KKR Private Equity Investors, part of Kohlberg Kravis Roberts, has agreed to invest $700 million in the computer maker. The investment will take the form of convertible notes, with half the convertible bonds due in 2012 and half in 2014. In addition, KKR will nominate a director to join Sun's board.

"I think it is a no-lose move for Sun," said Sanford C. Bernstein analyst Toni Sacchonaghi. It provides the company with "cheap financing, access to the KKR network, and an extra, smart board member." And from KKR's perspective, "It gives KKR a detailed inside look if they ever wanted to take Sun out," he said.

But buyouts are not on Sun's agenda. "We don't have any intention of going private," Bret Schaeffer, a vice president of finance, said in a conference call with reporters, adding that the funding will be used for strategic purposes such as acquisitions. He characterized KKR as a "high-quality, long-term investor."

There are barriers to a buyout, too. Sun spokeswoman Kathy Tom Engle said a standstill agreement prevents KKR from taking more than a 5 percent stake in Sun. Changing that arrangement would require approval from Sun's board, she said.

And a source familiar with the situation said KKR currently has no plans for future investment, and the current investment isn't a foothold for an eventual buyout.

Schwartz called the KKR investment a positive development: "This is a strong endorsement of our strategy and our management team by one of the premium private equity firms," he said. "We will use the proceeds to pursue strategic opportunities for growth."

The KKR investment effectively gives Sun $700 million at a 3 percent interest rate, the company said, which means even if it did nothing with it but invest it at market rates, it could make money.

Schwartz called the move an "opportunistic transaction." "We certainly don't need the money," he said. The company had cash and marketable securities of $4.84 billion at the end of the quarter.

In a statement, KKR founding member George R. Roberts praised Sun's new CEO. "Jonathan Schwartz and his team have demonstrated remarkable vision and strong discipline in executing its turnaround strategy...We are pleased to have the opportunity to pursue this investment through KKR Private Equity Investors in order to help Sun to best capitalize on its substantial growth potential."

Others saw more aggressive possibilities in KKR's move, though.

"Sun's financials make it an attractive buyout candidate," said Technology Business Research analyst Martin Kariithi. "Operating expense has been way too high for as long as I can remember. I expect KKR to exert its influence to spur more aggressive operating-expense cuts, improving near-term operating leverage."

KKR bills itself as "one of the world's oldest and most experienced private equity firms specializing in management buyouts."

KKR became well known in the 1980s for its high-profile leveraged buyouts (LBOs), particularly its $25 billion deal in 1998 to take over Nabisco. The deal was, at the time, the highest price paid for a corporation and became the subject of the book Barbarians at the Gate: The Fall of RJR Nabisco.

During the LBO craze of the 1980s, the acquiring firms took on large amounts of debt to buy companies that were considered to be underperforming. The debt often came in the form of bonds that were dubbed "junk bonds," indicating both their high yield as well as their lack of investment-grade ratings. The acquired companies were often broken up and sold piecemeal to help pay the debts, while management focused on improving core operations that were not spun off.

Sun on Monday announced a partnership to sell servers with Intel's Xeon chips beginning in the second quarter of 2007. That deal won't result in significant revenue that quarter, however, Chief Financial Officer Mike Lehman said.

Also for the quarter, Sun said its x86 server revenue grew 46 percent compared to the year-earlier quarter, and its Sparc server revenue increased 18 percent. Niagara system sales tallied more than $125 million. In addition, Sun sold about $20 million worth of its Sun Fire X4500 "Thumper" systems, a compact dual-processor server with as much as 24 terabytes of built-in storage, Lehman said.

Sun's gross margins, a measure of profitability, exceeded the company's expectations, and helped contribute to $153 million in cash flow generated from operations, Lehman said. "Frankly, we had expected to use cash during the quarter," he added.

Sun had posted revenue increases in its recent quarters compared with the year-earlier periods, but those comparisons were complicated by the fact that much of the gains came from the company's acquisitions of storage specialist StorageTek and software SeeBeyond. The 7 percent revenue increase for the last quarter of 2006, though, compared Sun's performance for the first time with a quarter in which those businesses had been integrated.